America’s Deflation Hysteria

December 19, 1997 • Commentary
This article appeared in Bridge News.

“The price level is falling, the price level is falling!” That’s what the Chicken Littles of the marketplace keep telling us.

The economy, alleged to be poised on a knife edge with rising prices on one side and falling prices on the other, is about to take a deflationary nose dive.

Why? because of “overcapacity.” The quantity of goods being produced is too large for consumers’ demand, forcing businesses to go begging. In short, the U.S. economy is about to fall victim to its own burgeoning productivity.

Well, the Chicken Littles are right about one thing: Recent improvements in productivity have been putting downward pressure on product prices.

But the claim that this spells disaster for the U.S. economy is hopelessly birdbrained. First of all, deflation is not inevitable, notwithstanding the extent of improvements in productivity or the vigor of global competition.

The Federal Reserve remains as capable as ever of expanding the money stock, thereby placing upward pressure on prices. But even though the Fed has the power to halt a productivity inspired deflation, it should resist doing so.

Why? Because a general decline in prices linked to general improvements in productivity is economically beneficial.

Rising productivity means declining unit costs of production. A given amount of labor, capital, and natural resources yields more output than before.

When unit production costs fall, businesses can pass the lower costs on to consumers in the form of lower prices without sacrificing profits.

Suppose that the Acme Widget Co. used to produce 100 widgets a week and sell them for $100, or a dollar each.

After a productivity improvement, using the same inputs, Acme produces and sells 104 widgets. If it now sells the widgets for only 90 cents each, its total revenues and profits remain the same. Because unit production costs have fallen, the price per widget can be reduced painlessly.

Such “benign” price cuts are a normal part of economic activity, an aspect of the rivalrous quest for customers. Far from hurting producers, it helps them to compete more effectively.

Notwithstanding claims to the contrary, recent price cuts have resembled the widget price cut mentioned above.

According to recently released figures, U.S. productivity has been growing at a remarkable 4.5 percent annual rate, meaning that the general price level could have fallen by the same percentage rate without generally impairing producers’ revenues or profits, and without heralding any decline in consumer spending.

In fact, Fed‐​supported money creation has prevented prices from falling much in response to productivity gains. Consequently, far from shrinking, the demand for goods has been rising steadily.

The Great Depression is ancient history. It’s high time people get over their fear of falling prices.

Personal incomes and consumption spending, for example, have been rising steadily in recent months. Salaries and wages show a similar, gradual and steady upward movement.

Consumers, in short, have more money to spend than ever.

To the extent that prices have declined in recent months (as they may have done, given some upward biases in the consumer price index), the increase in consumers’ earnings translates into an even larger increase in consumers’ real purchasing power.

What is so scary about that? Indeed, if there is anything wrong with recent Fed policy, it is that it has not been deflationary enough.

In acting to limit productivity‐​based deflation, the Fed has allowed consumer spending to grow excessively. Expanded spending eventually forces an upward adjustment in wage rates and other input prices.

Because input prices tend to adjust more sluggishly than output prices. this process may involve some substantial, if temporary, distortion of relative price signals that guide economic activity.

The Fed would do less harm by allowing output prices to fall to the full extent of underlying productivity gains. Similar reasoning favors allowing the price level to rise in response to a setback to productivity, such as a war or an oil shortage.

Nobody predicts Armageddon when, say, the price of computers declines year after year. Everyone understands that the drop in prices has nothing to do with a shortage of consumer demand but is rather due to productivity improvements in the computer industry.

Yet when similar improvements start happening all around, and so affect the general price level, doomsayers start squawking. It is as if they just can’t conceive of the possibility of general improvements in efficiency making most people better off, with the gains being transmitted via lower prices.

Why such a blind spot? The answer, in three words, is the Great Depression.

The early 1930s witnessed a massive decline in prices caused, not by improvements in productivity, but by a collapse of the money supply and consequent drying up of consumer spending.

As spending fell, so did earning, and many people found it impossible to pay their debts. Deflation thus suffers guilt by association, with depression.

People have forgotten all about other eras, like the 1880s, when falling prices were associated with rapid economic growth. Some are even convinced that an economy can thrive only with the help of a continuously rising price level.

Well, the Great Depression has been over for more than half a century, and it’s high time that people got over their fear of falling prices.

Of course, a recurrence of the 1930s monetary contraction should be avoided at all costs, but this is a simple matter of the Fed’s keeping its eye not on the price level but on direct measures of spending — such as personal income, nominal gross domestic product or domestic final demand.

As long as those numbers don’t shrink, the Fed can rest easy.

No matter what the Chicken Littles may say, the Fed should not feel compelled to ease the money supply in response to a mere downturn in the consumer price index. I suggest that the rest of us ignore the squawking and go shopping.

About the Author
George Selgin

Senior Fellow and Director, Center for Monetary and Financial Alternatives